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Markets & Economy

What's driving munis? Detroit, tapering, and interest rates

October 10, 2013

Lula Tadesse: Hello, and welcome to Vanguard's Investment Commentary podcast series. I'm Lula Tadesse. In this month's episode, which we are recording on September 24, 2013, we're going to discuss the municipal bond market in light of Detroit's bankruptcy, volatility in Puerto Rico, and concerns around the Fed's eventual plans to pull back its $85 billion-a-month bond-buying program. Here to discuss these topics is Chris Alwine, who heads Vanguard's municipal bond operations. Welcome, Chris.

Chris Alwine: Great to be here today, Lula.

Lula Tadesse: Over the past year, the bond market has seen a large increase in yields and unusually negative returns. What's going on?

Chris Alwine: Well, Lula, when we look back over the past year, we've seen interest rates rise about 150 basis points, and that was precipitated by the Fed's talk of tapering or reducing the rate of purchase of their Treasury and mortgage securities that were part of "quantitative ease."* Now if we go back a year, our view was that the Fed was suppressing rates by about that amount based on the policies that they had in place. And so the market has unwound the richness that was in place, brought on by the policy, based on those expectations that they would be reducing the policy to zero by the middle of next year.

Lula Tadesse: Has the Fed's recent decision to postpone its stimulus program impacted the fixed income market in general?

Chris Alwine: It has. That one came as a surprise to the market. Most market participants felt that they were going to begin the taper in September, and what we've seen is a 30-basis-point rally, or 0.3 percent decline in yields, since the Fed announcement.

Lula Tadesse: When the Fed does start tapering its stimulus program, how do you think it will impact the muni market?

Chris Alwine: We have to take a step back and look at what would prompt the Fed to reduce the tapering, and there's really two drivers. The first driver, is they need to have confidence in the durability of the economy—the economic growth rate—and they're really looking to see growth rates that are north of 2 percent. The second driver is that they have to view that the cost-benefit of quantitative ease is still attractive, and so, as they grow their balance sheet and have larger impacts in the market, there is a risk of bubbles forming, or ultimate inflation. And so either of those could precipitate or drive the decision to taper.

We would expect to see rates a little bit higher than they are today once they begin tapering, and the reason for that is, first, the economy will be doing a little better. And then second, there will be less Fed demand for securities that have kept rates lower to date.

Lula Tadesse: There's been a lot in the news about Detroit's bankruptcy, the largest municipal bankruptcy ever, and it's still in the works. What's next for Detroit, and are there broader implications for the muni market?

Chris Alwine: Detroit's bankruptcy does have the potential to set some precedence in the municipal market. It's really the first large bankruptcy that took on pensions that are protected by collective-bargaining agreements as well as constitutional protections—in this case, in the state of Michigan. We'd expect to see a ruling whether Detroit is actually eligible for bankruptcy by the end of the year. At that point in time, assuming they are eligible, then the city, or the emergency manager in this case, will submit a plan of adjustment. And this is where it has some broader implications for the market and really centers around the treatment of unlimited tax general-obligation bonds. These are voter-approved bonds that are secured by the ability to tax the citizens of Detroit. Historically, these have been viewed as supersenior, with very high recovery rates in times of bankruptcy. Recovery rates are approximating 100 percent.

Now, the emergency manager has categorized these at the same level as pensions and so forth. And so that would imply a lower recovery value. If the judge rules along those lines, it will have implications for lower-rated municipals. So think of local GOs [general-obligation bonds] that may be rated in the BBB category that have more debt or larger pension implications, that we would expect to see those bonds underperform as their yields rise to reflect the higher risk.

Lula Tadesse: Puerto Rico has also been in the news, and a lot of mutual funds include Puerto Rico in their portfolio. Can you give us an update on what's happening there?

Chris Alwine: Yes, Puerto Rico has been in a period of sustained economic decline. When we look at the drivers of that, it really comes down to a few. The first is the removal of a tax preference that encourages businesses to locate in Puerto Rico; secondly is globalization; third is the great recession that we've all been living through; and then, lastly, outmigration. These four drivers have reduced the realized rate of economic growth. In fact, Puerto Rico's been in recession for the past five years. But it's also reduced the potential economic growth rate of Puerto Rico.

Now, to address these challenges, the new governor has instituted a number of reforms. It's too early to tell whether they're going to succeed; we are going to be watching that carefully.

Lula Tadesse: So to what extent does Detroit, and even Puerto Rico, reflect the creditworthiness and fiscal health of the municipal market as a whole?

Chris Alwine: Well, we view Puerto Rico and Detroit as outliers. These are entities or issuers that have been in a period of challenged and sustained economic decline. There are certainly actions being taken on the part of Puerto Rico to try to address those challenges. Also, if you look at the historical default rate, precrisis we saw about one default a year in the municipal market. Currently, we are seeing about five defaults a year. If there's 50,000-plus issuers, you can see in context, it's a very, very low number.

Lula Tadesse: We've discussed some of the challenges facing munis. But muni yields are quite attractive compared to Treasuries right now. Does that mean investors should jump in and take advantage?

Chris Alwine: When we look at the relative valuations between the taxable and municipal markets beyond ten years, munis do look attractive on a historical basis, at about 112 percent of Treasuries. Inside of ten years, we would call munis about fair to Treasuries, at around 95 percent. Now, one added advantage of munis in this environment is the higher tax rates—the increase in federal taxes—and in some cases, state taxes—have increased the attractiveness of munis. Now I do want to caution about jumping in. Jumping in implies a market-timing component to that, and market-timing is very challenging because it requires two correct calls: when to get in, when to get out. Vanguard has always recommended a thoughtful planning to building investment portfolios that focuses on the proper asset allocation that reflects investors' return objectives and risk tolerances.

And then also, having a long-term perspective—very important, because it allows you to tune out the noise that's ever-present in the markets.

Lula Tadesse: So in light of all of this, what should investors and their financial advisors consider when investing in muni funds?

Chris Alwine: There's really three things that advisors and investors should be focused on today. The first is cost. Cost is a big driver of return in fixed income products in particular, and so I would understand the costs that you're paying to invest in a specific mutual fund.

The second is to recognize the longer-term attractiveness of municipals relative to other fixed income alternatives in a risk-reward space. If we think of the efficient frontier that looks at total return versus risk, munis have looked very attractive in that framework, and that comes from two reasons. The first is that muni interest rates tend to move about a third less than taxable rates. And then, secondly, if we look at yields of munis on a tax-equivalency basis, they tend to exceed taxable counterparts.

And then, lastly, watch out for managers that are taking excessive risk. When risk is on and risk is doing well in the marketplace, managers who have extended duration, gone down in credit quality, concentrated their portfolios, tend to do well. But when the cycle turns, often associated with the Fed raising interest rates, investors can be surprised at the level of underperformance that is realized in aggressively managed portfolios.

Chris Alwine: I would expect we are going to be in a period of higher volatility—interest rates going up and down more than we would typically see in the municipal market.

When we look at rates, we'd expect to see 10-year Treasuries in the 2½ to 3¼ percent range, but with an upward bias over time, as we expect economic growth to move up from about the 2 percent range today into the 2½ percent range in 2014. Muni defaults should remain exceedingly low and then, lastly, to sort of wrap it up, municipals should remain an attractive fixed income component of a diversified investment portfolio.

Lula Tadesse: Chris, thanks for joining us today. We really appreciate your insights and your time. And thank you for joining us for this Vanguard Investment Commentary podcast. Be sure to check with us each month for more insights into the markets and investing. Thanks for listening.

*Quantitative easing refers to the monetary policy in which the Federal Reserve purchases securities, including bonds, in an effort to increase the money supply.

Notes:

For more information about Vanguard funds visit vanguard.com or call 877-662-7447 to obtain a prospectus. Investment objectives, risks, charges, expenses and other important information about a fund are contained in the prospectus. Read and consider it carefully before investing.

All investing is subject to risk, including the possible loss of the money you invest.

Past performance is not a guarantee of future returns.

Diversification does not ensure a profit or protect against a loss.

Bond funds are subject to interest rate risk, which is the chance bond prices overall will decline because of rising interest rates, and credit risk, which is the chance a bond issuer will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer's ability to make such payments will cause the price of that bond to decline.

Although the income from a municipal bond fund is exempt from federal tax, you may owe taxes on any capital gains realized through the fund's trading or through your own redemption of shares. For some investors, a portion of the fund's income may be subject to state and local taxes, as well as to the federal Alternative Minimum Tax.

While U.S. Treasury or government agency securities provide substantial protection against credit risk, they do not protect investors against price changes due to changing interest rates. Unlike stocks and bonds, U.S. Treasury bills are guaranteed as to the timely payment of principal and interest.

An episode from Vanguard's Investment Commentary podcast series

Chris Alwine, head of Vanguard municipal bond operations, shares the firm's outlook for the municipal bond market including Detroit's bankruptcy, volatility in Puerto Rico, and uncertainty surrounding the Fed's plans to taper its $85 billion-a-month bond-buying program. He also discusses what investors and their advisors should consider when investing in this unusually volatile muni bond environment.

Notes:

All investing is subject to risk, including the possible loss of the money you invest.

Bond funds are subject to interest rate, credit, and inflation risk. Although the income from a municipal bond fund is exempt from federal tax, you may owe taxes on any capital gains realized through the fund's trading or through your own redemption of shares. For some investors, a portion of the fund's income may be subject to state and local taxes, as well as to the federal Alternative Minimum Tax.